So much for the background. Now for the anomaly—the anomaly which lies at the heart of Planet Ponzi.
Over the period 1998–2010, Main Street banks have contributed about 3.6% to total economic output, and they have made about 3.6% of all profits in the US economy. That’s more or less what you’d expect. The banks do a job. They make some money, but not vast amounts. They simply earn a regular slice of profit by way of reward for doing what they do.
The same tedious logic, however, stops applying when it runs up against the ‘other financial’ sector—the term given by the government’s statisticians to Wall Street and insurance companies. That ‘other financial’ sector contributed just 4.3% to economic output over the same period, yet took a staggering 28.9% of all American profits.5 That fact is so astonishing it bears repeating. Just under 30% of all profits made in the US economy were being made either on Wall Street or in insurance. And there’s more. Wall Street pay is notoriously lavish, bonuses exceptionally large. Those things are counted as expenses, deductions against profit. If pay on Wall Street were halfway normal, the sector’s profits would be even higher. And, of course, I’ve quoted an average figure. In the boom years of 2002 and 2003, that ‘other financial’ sector generated profits equal to 40% of the total. Two-fifths. From a sector that represents about one-25th of the nation’s output.
There is, let us remember, nothing inherently sinful or suspicious in people making profits, even big ones. For example, if you scraped around in your backyard and found some rich and easily accessible gold deposits, you would quite likely make some extremely large profits. Those profits would last as long as your gold deposits remained rich and easily accessible. You wouldn’t have done anything unethical in exploiting them; you’d just have been very lucky.
And you don’t need to stumble across an oil well or a gold mine to strike it rich. Google and Microsoft are examples of firms smart enough and lucky enough to have created virtual gold mines of their own. The nature of computer operating systems and search engines appears to favor the largest player. You couldn’t say that either firm is immune from competition, just that the forces of competition don’t work to drive down prices in the way that they do for more ordinary markets, like the ones for pressed steel, or cookies, or handsaws, or haircuts.
There are other ways to create gold mines. Cartels—price-fixing agreements among supposedly rival suppliers—are a classic way for firms to boost their profits at the expense of consumers, which is why cartels are generally illegal. Any government regulation that makes it hard for new firms to enter an industry always boosts the profits of the protected firms. So, in one notable recent instance, the Italian government (led by Silvio Berlusconi) proved curiously unwilling to allow free competition in the TV industry—much to the advantage of the sector’s dominant player (which just so happens to be owned by Silvio Berlusconi).
All these examples—gold in the backyard, Google, cartels, inappropriate government regulation—have one thing in common: an absence of ordinary competition. In normal industries, any profit windfall is soon winnowed away by the rush of incoming competitors. That’s why, as it happens, it’s not worth your while scraping around in your backyard for gold. Any such easy gains were scooped up a long time ago. That’s why the gold rush was a rush, not an amble.
So far, so obvious—so what are we to make of those financial profits? Wall Street may be greedy, blind, duplicitous, dishonorable, and a thousand other things, but one thing it is not is uncompetitive. Quite the reverse. It’s difficult, indeed, to think of any industry where competition is more vigorous. Firms compete furiously for talent. They steal talent from other firms. They pitch hard, market hard, price keenly, incentivize massively. There are plenty of big firms generating competition all by themselves, and there are always plenty more competitors, from both the US and overseas, ready to enter the market and snatch whatever business they can from the better-known incumbents. Barclays, RBS, UBS, Deutsche are only some of the more prominent would-be entrants to this golden industry; the truth is that every sector of finance—every subsector, even—is a seething mass of firms struggling to get an edge over their peers. Wall Street may not be pretty, but it’s Competition Central and it has been for years.
But competition erodes profit. It drives it down to the level where firms earn a fair return for their commitment of capital and energy, but no more. As far as all economic logic is concerned, those pumped-up Wall Street profits shouldn’t exist. What’s going on?
So far, our discussion has assumed that the commercial world splits neatly into two: financial firms on the one hand; nonfinancial ones (the truckers, the widget-makers, and so on) on the other. We’ve assumed that firms in the second group make money in pretty much the way you’d expect them to: carrying things on trucks, making widgets, and so forth. But that’s not quite accurate. Certainly the finance guys don’t get involved in things that might make their hands dirty, but those in the regular economy are by no means averse to picking up financial profits themselves.
In a remarkable 2005 study, Greta Krippner sought to explore the degree to which profits now accrue ‘primarily through financial channels rather than through trade and commodity production.’6 In particular, she measured the ratio of portfolio income (interest, dividends, and capital gains) to total corporate cash flows. In effect, she was looking at the degree to which nonfinancial firms were earning their money through financial means.
Her results were extraordinary. From 1950 to 1970, financial profits averaged less than 10% of the total. Naturally, widget-makers might find they had some cash on deposit and would earn some interest from it, but broadly speaking they made money the good old-fashioned way: by making something for $0.90 and selling it for $1.00. Then, in 1970, something started to change. The key ratio started to rise and rise. By the end of the 1980s, nonfinancial firms were earning more than 40% of their total through financial means. After a slight dip in the 1990s, the ratio returned to that 40% level in time for the millennium.
These figures are disconcerting in the extreme. One of most obvious features of the financial system is its theoretical symmetry. If I lend you twenty dollars and charge you a dollar in interest, that dollar is my income, but your expense. They cancel out. Aggregated over an entire economy, we should find that there is no net interest at all, except to the (relatively modest) extent that it comes in from overseas. Something similar applies to dividends and capital gains. If I grow a business and sell it for a good profit, I’ll earn a capital gain. Yet such gains—and, indeed, any dividends—arise ultimately from growth in ordinary, regular, run-of-the-mill profits. If those profits have become ever less important to the overall economy, what on Earth is keeping those financial profits afloat?
These questions are not easy to answer, but the more you reflect on them the more you realize you are left with only two possible options. When it comes to those bizarrely high Wall Street profits, you can choose to believe one of the following two propositions:
over the last couple of decades, Wall Street has become the first industry in the history of capitalism to have consistently super-sized profits despite continual aggressive competition; or
those pumped-up profits are a mirage—or, in plain language, a Ponzi scheme.
Your choices are broadly similar when seeking to account for the bizarrely large proportion of financially derived profits found in the accounts of nonfinancial corporations.
Perhaps even the second conclusion doesn’t go far enough for you. Indeed, it’s quite possible that a further reflection has already occurred to you, namely:
Of course Wall Street has pumped-up profits; its activities have no social utility at all and it basically exists only to steal money from the rest of us, so why wouldn’t it make monster profits? That’s what thieves do.
If that’s what you’re thinking, then I like your style. As it happens, though, I don’t think that W
all Street is only about theft. Companies do need to raise capital. Bonds and equities do need to be tradable in liquid markets. And so on. The core of Wall Street’s traditional businesses make good economic sense, just as they always have done. But still: I like the way you’re thinking.
Nevertheless, even allowing for some exaggeration, I can’t agree with you. The laws of economics don’t go to sleep just because an activity is socially worthless or even harmful. The purveyors of high-cholesterol, obesity-promoting meals compete hard with each other. Polluting chemical plants compete with one another. Tobacco firms compete. And that’s what matters: the simple act of competition forces profits down to a normal level. You can even see the same thing with the trade in illegal drugs. As Steven Levitt and Stephen Dubner showed in Freakanomics, most drug dealers live with their moms, simply because there are too many drug dealers competing for too little business.7 Barriers to entry are low. Profits get forced down and down. It’s competition that does this. The social value of the activity doesn’t come into it.
But maybe your mind is moving along other lines. Perhaps you don’t like conspiracy theories as a rule. Perhaps you think that the simplest explanation is always the likeliest one: Neil Armstrong really did walk on the moon, the CIA did not kill President Kennedy, Elvis is dead. I’m the same. I don’t like conspiracy theories either. So here are two further propositions, either of which you might find attractive:
Mitch Feierstein is an idiot or a liar, and he’s gotten his figures wrong; or
Mitch Feierstein has his figures quite correct, but there is some other perfectly innocent explanation of these data—we don’t need to invoke a giant Ponzi scheme.
If you had doubts along these lines, congratulations. I don’t want you to take things on trust. Taking too much on trust is a big part of what got us into this mess in the first place.
So let’s go with your objections. You don’t like my figures? Then please check them out. I’ve sourced my data on financial sector profits from the Bureau of Economic Affairs, the government agency charged with compiling these figures. The data are all available online. The notes at the end of this book tell you just where you can find them. There are a few little complications to deal with—changes in certain industrial categorizations, for the most part—but nothing major. Nothing that has direct bearing on the argument of this chapter. If you’re even half-competent with a spreadsheet, you should be able to reproduce the data in this chapter yourself. It’s basic arithmetic, not quantum mechanics. Greta Krippner’s figures are harder to reconstruct, but she too drew her data from impeccable government sources and has provided extensive details of her methodology. The fact is that if she’d messed up her figures, someone would have noticed. The same goes, in general, for all the data in this book. If you don’t believe me, go check for yourself. Please.
As for the possibility of some other, more innocent explanation—well, if you think it’s there, go find it. I’m not the first person to have noticed the scale of those financial profits. They’ve attracted widespread comment over the years. But so far as I know, no one has an explanation of why they’re so large in relation to the broader economy. If you don’t believe me, go online, browse the views of other commentators, and put me to the test. Bear in mind that the whole of economic theory since Adam Smith argues that competition drives returns on capital down to normal levels, which means that if you do find an ‘innocent’ explanation of Wall Street’s profits that attracts you, it’ll be you on one side of the fence and all of economic science on the other. So good luck with that.
In short, once you’ve done all the due diligence you can, I think you’ll come back to my original two propositions. Either Wall Street is a modern miracle, the only industry in history that has learned how to levitate. Or those profits aren’t really there at all. They’re bogus. A con. A huge, expensive, Ponzi-ish con.
Of course, it’s not much use providing the evidence of this con, if we can’t demonstrate precisely how those bogus profits arise and what keeps them going. So that’s where we’ll turn next.
9
A house for Joe Schmoe
When Joe Schmoe—a GI with an honorable war record—returned from the Pacific, he found his girl waiting for him. To begin with, they went out on a couple of trial dates, getting reacquainted with each other. There was a little awkwardness at first, but they soon got over it. One thing led to another, until one day Joe proposed to his girl—I’m seeing her as a Betsy, all plump cheeks and flowered aprons. Betsy said yes. Joe found a good job as a production worker. He and Betsy got married (and everyone cried and said what a lovely couple they were). Now they needed a house. So Joe put on his best suit, went to his local bank, the First National Bank of Pumpernickel Creek, and asked for a mortgage.
The house Joe wanted to buy cost $1,000. He had $200 in savings. So he asked to borrow $800. The manager at First National (let’s call him Jefferson Smith) wanted to check out the steadiness of Joe’s job, the reliability of his income, and the soundness of the proposed collateral (the house). Having satisfied himself on those points—and recognizing that he was about to make a commitment that might endure for more than two decades—the bank manager approved the loan. Joe and Betsy bought their house. They raised three apple-cheeked and healthy children and naturally lived happily ever after. Joe’s personal finances were almost as simple as his family history. He started out with an asset ($1,000 worth of house), a loan ($800), and equity in the house for the remaining $200. As time went by, he paid down the loan. His equity increased. And as the high quality of life in Pumpernickel Creek became more widely known, the value of the house went up too, thereby further enhancing Joe’s equity and the family’s prosperity.
The financial position for the bank was a little more complex, but only a little. Even in Pumpernickel Creek, money doesn’t grow on trees. The $800 advanced by the bank had to come from somewhere. To some extent—let’s say, to the tune of $150—the money would have come from the bank’s own capital resources: that is, money belonging to the bank itself, not owed on to anyone else. But that still leaves a gap of $650 to be filled, almost certainly with money which would have come from reinvesting customers’ deposits. To keep the story simple, let’s say that old Mrs Salzundpfeffer, one of the town’s most respected inhabitants, chose to place exactly that amount of money on deposit at First National. So the bank’s balance sheet looks like this: an asset of $800 (the mortgage which Joe Schmoe has to repay), a liability of $650 (the money which the bank will one day have to pay back to Mrs Salzundpfeffer), and equity of $150. Simple.
Equally simple is the way that everyone’s motivations, risks, and incentives are aligned. If Joe wants to keep a roof over Betsy’s head, he needs to keep up the payments on his mortgage. If the bank doesn’t want to lose its shirt, it’s going to take a good hard look at the quality of Joe’s income and the value of his collateral. If those things are unsound, the bank will lose money. If Mrs Salzundpfeffer isn’t going to lose her nest-egg, she’ll be sure that First National has a deserved reputation for sound, conservative banking.
In this happy scenario, the logic extends to the income statement as much as the balance sheet. Joe doesn’t want to pay too much for his mortgage; Mrs Salzundpfeffer wants a decent return on her savings. The bank can certainly make its turn in the middle, but never too much, because otherwise borrowers or depositors or both will go elsewhere.
This simple banking system can’t avoid risk, because no banking system ever can. Maybe Joe Schmoe will be killed in an industrial accident. Maybe his house will blow away. Maybe these terrible things happen and a crucial insurance policy fails for some arcane reason. Maybe Joe isn’t the straight-up guy we all thought him to be. Maybe Jefferson Smith is on the take. (Impossible!) Nevertheless, the system is as robust as you could want it to be. The bank is going to think hard about loan quality, because if those loans go bad, they injure the bank and no on
e else. No one is exposed to any credit risk from Joe Schmoe except the very people who looked hard into his credit history and decided that the risks were acceptable.
That system was a thoroughly sound one. Sure, it still needed plenty of government regulation around it, plus government deposit insurance to protect depositors from badly managed banks. What’s more, with hindsight, we can see plenty of innovations that were able to help cut costs or improve risk management. Nevertheless, the basic model was sound. Risks and incentives were perfectly aligned.
Now let’s jump six decades and take a look at how things worked for Joe’s grandson, Joe Schmoe III. Unfortunately, somewhere down the line, the fine genes bequeathed by the original Joe and Betsy Schmoe have become seriously damaged. The new Joe has something of an alcohol problem. He’s been in trouble with the law. He hasn’t married his girlfriend, Joella, but has two kids with her nevertheless. They are living in a trailer park somewhere in California. The pair talk about getting themselves sorted out, but at the present moment they are twenty-first-century NINJAs: No Income, No Job, No Assets.
We’re about to take a look at how the financial system of the last decade handled Joe and Joella’s finances. We’re going to take a look at the risks and the incentives in the system and see how they did—or did not—align. But before we proceed, a word of warning. If you’ve had any prior interest in these topics, you will already have read about the subprime mortgage problems which precipitated the first wave of the present credit crisis. So before we proceed, let me be clear: although I am using the mortgage market as the clearest possible illustration of how things can (and did) go wrong, my argument is general, not specific. I believe the problems we’re about to look at—wildly escalating leverage, ballooning risks, disastrous incentives, lousy accounting, incompetent investors—are extremely widespread. They were, and are, not unique to the mortgage market. They are still highly prevalent in market after market today. What follows is a specific illustration of a general phenomenon. Until these general issues are addressed, we have a financial system which is more like a Ponzi scheme than a useful tool for the effective deployment of capital. What we have, in fact, is not a socially useful asset; it’s a ticking time bomb.
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